Documentary Credit World

This article attempts to provide a brief overview of the legal practice regarding letters of credit in the context of bankruptcy law and procedures, along with an analysis of notable past cases in Chinese courts.

When a bank issues an LC based on an applicant's request to a beneficiary, it raises a significant issue for the bank if the applicant encounters financial difficulties and cannot repay the bank’s advances except for the previously collected deposit or other form of collateral or guarantees. The issuing bank is primarily concerned with the rights it holds on the documents of title it has handled, such as a bill of lading.

We will find that when issuing an LC, banks often only collect a 10% or 20% cash deposit of the LC amount from the applicant or even no deposit at all. Why do banks issue LCs with such a small deposit? It is because of the self-liquidating nature of commercial LCs. For the entire transaction, the bank has two types of collateral: one is the applicant's deposit and the other is "documents of title," such as the bill of lading submitted by the beneficiary or presenting bank, and warehouse receipts.₁ The bank's rights and interests on these documents are particularly important. So, the reason why an LC is self-liquidating is because the bank already holds very appropriate collateral. If the LC supports a transaction involving bulk commodities such as oil, soybeans, or metals, it typically requires presentation of all original documents, such as bills of lading and warehouse receipts, to the issuing bank which controls all the documents and the rights represented by these documents to extract the goods.

If a bank has a security interest on the documents and the goods represented by those documents, and this security interest is perfected through delivery, transfer, registration, control, or possession, then the bank not only enjoys a priority right on the documents and the goods they represent but also has the ability to assert this right against third parties (third party effectiveness). In this scenario, the reason the bank only collects a cash deposit of 50% or less is because the bank effectively controls these documents of title.

In practice, many banks do not have well-designed letter of credit agreements. Therefore, this article will focus on legal and operational issues that arise for the issuing bank prior to sending its letter of credit acceptance message or making a payment advance. This may include situations where the customer needs to add additional margin or collateral or when the bank has to pursue recovery in the event that the customer, i.e. the LC applicant, declares bankruptcy.

China Construction Bank Co., Ltd. Guangzhou Liwan Branch v. Guangdong Lan Yue Energy Development Co., Ltd.₂

The issue in this case, referred to as the "Lan Yue Energy Case" revolves around the dispute arising after China Construction Bank (Issuing Bank) issued an LC for its client, Lan Yue Energy (Applicant). Upon presentation of documents by the beneficiary, Issuing Bank determined the documents to be compliant, sent an acceptance message to the beneficiary, and paid at maturity. However, at this moment, the Applicant encountered financial difficulties and was unable to make payment to Issuing Bank to redeem the documents. As Issuing Bank lacked the capacity to sell the underlying product (in this case, coal) already unloaded at the port, problems arose.

LC Applicant Encounters Financial Difficulties

In this case, Issuing Bank signed an Import Trust Receipt Agreement with Applicant when issuing the LC. However, when the documents reached Issuing Bank, it found that its customer was facing financial difficulties and could not make payment to it for the redemption of the documents. As a result, Issuing Bank had no choice but to hold the full set of original bills of lading while the goods under the bills of lading were unloaded at Fangcheng Port in Beihai, Guangxi, China.

Competing Claimants: Issuing Bank Faces Risks and Challenges

Due to Applicant's arrears in port charges in Guangxi, the goods were seized by port authorities for the exercise of the right of retention. Subsequently, other creditors of Applicant exerted claims on the goods in question. As a result, Applicant and its creditors applied for bankruptcy or restructuring. This complicated the situation for Issuing Bank. The Applicant's customer was unable to make payment for the redemption of the documents, and at the same time, the bill of lading was in the possession of Issuing Bank. However, the coal unloaded under the bill of lading at the port was claimed by the port. Furthermore, other creditors of Lan Yue Energy emerged to compete with Issuing Bank for priority rights over the goods under the original bill of lading. Therefore, the security rights that Issuing Bank held on the bill of lading and the goods it represented became crucial. If Issuing Bank does not have any collateral or priority rights to counteract competing claims, the funds from the coal may be seized by others.

Priority Rights and Counteracting the Rights of Third Parties: The first-instance trial at the Guangzhou Intermediate People's Court₃ and the second-instance trial at the Guangdong High People's Court ₄

At this point, Issuing Bank needed to pursue whether it had priority rights. Firstly, it needed to ascertain if there were any collateral interests. If so, what type and were they ownership, retention, or pledge rights? Secondly, it needed to determine whether its rights could counteract those of third parties.

The outcome of this case was a surprise. Issuing Bank unexpectedly lost in both the first-instance and second-instance trials. Afterwards, an application for retrial was submitted to the Supreme People's Court. The decision rendered by the judges, including Liu Guixiang and Gao Xiaoli, was exceptionally well-crafted. The court dedicated a significant portion of the decision to discuss what rights Issuing Bank actually had on the bill of lading. The judges determined that because neither the buyer nor the seller intended to transfer ownership of the goods under the bill of lading to Issuing Bank, holding the ocean bill of lading did not imply ownership rights over the goods. Therefore, the judges analyzed that the claim of ownership over the goods asserted by Issuing Bank under Chinese law was not tenable.

So, what rights did Issuing Bank actually have? Issuing Bank also asserted that it had a pledge right on the bill of lading. The Judges conducted a detailed analysis on this matter, stating that when issuing the letter of credit, Issuing Bank did not explicitly agree in writing with the applicant on the pledge right over the documents or goods. Instead, it was stipulated under Article 9, Section 2, Item 4 of the "Special Agreement on Issuing Letter of Credit": "If [Applicant] defaults or there is a situation that may jeopardize [Issuing Bank’s] creditor ’s rights, the bank can exercise [its] guarantee rights." In the same section of the agreement, Item 5 required Applicant to provide additional security or other guarantees acceptable to Issuing Bank. Therefore, there was no explicit written agreement on the pledge right between the parties. According to Chinese Security Law, a pledge right requires written agreement between parties.

In the end, the Judges pointed out through the method of contract interpretation that Issuing Bank should be recognized as having a pledge right over the bill of lading. Based on possession of the pledged assets, its priority rights can counteract those of third parties. Once the pledged priority rights of Issuing Bank were established, it could assert its priority. However, it was then discovered that the goods had significantly depreciated while stored at the port. Consequently, Issuing Bank may transfer this bad debt to an asset management company.

China Merchants Bank Co., Ltd., Ningbo Branch v. Liquidation Team of Zhejiang Shipbuilding Co., Ltd. ₅

This case of the Intermediate People’s Court of Ningbo involves the right to revoke bankruptcy. The debts of Zhejiang Shipbuilding (LC Applicant) involved in this case were new debts accrued within the year before acceptance of the bankruptcy application by the first instance court on 4 April 2016. The agreements between China Merchants Bank (LC Issuer) and LC Applicant, including the "Credit Facilitation Agreement" and the "Maximum Receivables Pledge Contract",₆ were all signed within the year before acceptance of the bankruptcy application. The signing of the first three agreements did not involve malicious intent, nor did it intend to defraud general creditors. The specific debts under the "Credit Facilitation Agreement" all fell within the category of new debts formed within the year before acceptance of the bankruptcy application. Among them, two letters of credit were issued on 16 September 2015 and 20 November 2015 within the year before acceptance of the bankruptcy reorganization application. The extension agreement for the working capital loan involved in the case was signed on 20 January 2016, materializing after the signing of the relevant pledge contract. The financial instruments involved in the case were re-issued, constituting new debts.

Providing pledge guarantees for new debts formed within the year before the acceptance of the bankruptcy application does not fall within the revocable scope as stipulated in Article 31 of the Business Bankruptcy Law of the People's Republic of China (PRC Business Bankruptcy Law). For the debts involved in this case, LC Applicant obtained new consideration and benefits concurrently with providing pledge guarantees, which is clearly different from the situations specified in the aforementioned provision.

The Liquidation Team of LC Applicant (Liquidators) argued that PRC Business Bankruptcy Law₇ Article 31₈, Section 3 does not explicitly require examination of the time of debt when accepting guarantees within one year before the bankruptcy application. Liquidators asserted that the acceptance of guarantees within one year before the bankruptcy application does not distinguish between old and new debts.

The Ningbo Intermediate People's Court determined that, according to this Section of the PRC Business Bankruptcy Law, if the debtor provides property guarantees for debts without property security within one year before the court accepts the bankruptcy application, the administrator has the right to request the court to revoke it. According to this provision, if the debtor, within the statutory period, provides property guarantees for debts without property security, it is considered a preferential disproportionate settlement. The rationale is that providing property guarantees for debts without property security will grant creditors a priority claim on specific property, resulting in individual disproportionate settlement, which contradicts the principle of fair settlement and should be revoked. The term "debts without property security" in the above provision can refer to debts outside the one-year period before the court accepts the bankruptcy application or debts within that one-year period. As long as the debtor did not provide property security at the time of establishment but provided it afterwards within one year before accepting the bankruptcy application, it should be revoked.

In this case, when the debts under the "Credit Facilitation Agreement" were actually established, including a capital loan, two domestic letters of credit, and seven guarantees, there was no property collateral. Moreover, the subsequent extension of the term and the delayed actions related to the guarantees are not considered as the re-establishment of the debt. Considering that there was no prior establishment of collateral or mutual agreements between the parties, there is no new consideration relationship between the extension of the mentioned loans and guarantees and the subsequent establishment of pledged collateral.

Furthermore, LC Issuer argued that the additional two guarantees involved in the case became true bankruptcy property in September-October 2016 (i.e., after the establishment of the pledged collateral). Additionally, it asserted that the two letter of credit debts involved in the case did not form within the year prior to acceptance of the bankruptcy application.

In conclusion, the subsequent provision of the highest amount of collateral, based on accounts receivable held by the opposing party, for the mentioned debts had infringed on the fair repayment rights of other ordinary creditors and should be revoked in accordance with the law. LC issuer had appealed that the property guarantees provided for the debts in this case do not fall within the revocable scope defined by PRC Business Bankruptcy Law Article 31.

Administrator of Ningbo Free Trade Zone Chuangshi International Trading Co., Ltd v. CHIMEI Corporation Ltd₉

In this case of the Intermediate People's Court of Ningbo, the plaintiff, acting as the bankruptcy administrator, stated that on 24 May 2017, the court ruled to accept the bankruptcy liquidation. The administrator found that from 2 December 2016 to 12 December 2016, Chuangshi International Trading Company LC Applicant made three payments totaling CNY 2,495,548.63 (USD 362,000) to CHIMEI Corporation's (LC Beneficiary) account through two letters of credit. This action prompted an investigation into the individual creditors and the bankruptcy administrator requested the court to declare the payments invalid.

LC Beneficiary argued that payment under the letter of credit was received as payment for goods from Huaxia Bank Ningbo Branch (LC Issuer). However, there was no payment relationship for goods between these parties. Therefore, the administrator was not the proper entity to request return of the funds. In fact, the applicant aimed to assert that the money paid by LC Issuer to the beneficiary was a disproportionate settlement.

Citing the LC independence principle, LC Beneficiary asserted that the funds obtained through the letter of credit were not affected by the commercial risks resulting from LC Applicant's bankruptcy. A letter of credit is a separate transaction from the sales contract and the bankruptcy of the applicant does not impact the independence of the LC. Even if the payment received by LC Beneficiary was directly from LC Applicant and subsequently handed over to LC Issuer, funds received by LC Beneficiary do not harm the overall interests of creditors and do not constitute an individual settlement.

The court determined that LC Applicant purchased poly (methyl methacrylate) sheets (plastic sheets) from LC Beneficiary and resold them to Weizhi Company. On 29 August 2016, LC Applicant applied to the LC Issuer and letter of credit (LC No. 1) was issued. The LC issued for USD 300,000 specified CHIMEI Corporation as the beneficiary, allowed any bank in Taiwan to negotiate, a bill maturity period of 90 days after sight, and LC Issuer as payer. Partial shipments were allowed and the goods were described as 50,000 plastic sheets and others. The LC stipulated the applicable rules being "latest UCP version." The LC also specified the documents required.

On 31 August 2016, LC Applicant signed three orders with LC Beneficiary, agreeing to purchase plastic sheets for amounts of USD 51,090, USD 40,032, and USD 118,608, respectively, with a payment term of 90 days via letter of credit. After LC Beneficiary shipped the goods, Mega International Commercial Bank (Negotiating Bank) paid for the goods on 6 September 2016, deducting the discount interest and fees.

On 19 September 2016, LC Applicant applied to the LC Issuer to issue another letter of credit (LC No. 2). This LC No. 2 was issued for USD 480,000 backing purchase of 65,000 pieces of plastic sheets. Other terms were consistent with those contained in LC No. 1.

In December 2016, LC Applicant, based on payment/acceptance notifications from LC Issuer, made three successive payments totaling CNY 2,495,548.63 under the two LCs. On 14 April 2017, LC Applicant applied for bankruptcy liquidation to Ningbo Intermediate People's Court. The court, in its ruling on 24 May 2017, stated that as of the end of December 2016, LC Applicant's total assets were CNY 1,122,473,517.77, current liabilities were CNY 1,667,825,937.86, and owner's equity was – CNY 545,352,320.09. Zhejiang Boning Law Firm and Zhejiang Dewei Certified Public Accountants Limited were appointed as joint bankruptcy administrators. On 19 February 2019, the administrators of LC Applicant initiated a lawsuit.

The Ningbo Intermediate People's Court first considered whether the administrators of LC Applicant had a right to bring a lawsuit to revoke the disproportionate settlement based on transactions under the LCs. The court held that the entities directly making payments to LC Beneficiary are not the counter-parties of the underlying transactions; instead, they are the confirming bank and the LC issuing bank. This flow of funds is a direct result of the arrangement of the LC. However, in the sales contracts between LC Applicant and LC Beneficiary, the choice of using an LC as the method of payment for the goods implies that the payment obligation under the sales contract is fulfilled when the LC payment is made. LC payment is, of course, considered payment under the sales contract; otherwise, LC Beneficiary could separately demand payment from LC Applicant according to the contract which would clearly contradict the purpose of the LC. LC independence does not negate its nature as a means of settlement. Therefore, the administrators of LC Applicant had the right to bring a lawsuit to revoke the disproportionate settlement based on transactions under the LC.

The court then considered whether settlement of the underlying transactions under the relevant letter of credit constituted a disproportionate settlement under the Business Bankruptcy Law and should therefore be revoked. According to Article 32 of the Business Bankruptcy Law, the conditions necessary for the establishment of a lawsuit brought by the administrators of LC Applicant must simultaneously meet the following criteria: 1. The settlement action occurred during the critical period of bankruptcy, i.e., within six months before the court accepted the bankruptcy application; 2. The debtor has already met the conditions specified in Article 2 of the Business Bankruptcy Law, meeting the conditions for bankruptcy; and 3. The settlement action itself qualifies as a disproportionate settlement.

In the present case, the payment terms agreed upon by both parties in the underlying contract were based on a 90-day LC. According to the issuance dates of the two LCs, it can be determined that LC Applicant settled its debts on 28 November 2016 and 18 December 2016. The court decided to accept the bankruptcy liquidation application from LC Applicant on 24 May 2017, placing the aforementioned settlement dates within the critical six-month period. Thus, the settlement in this case satisfied the first two conditions. As for the third condition, the nature of the transaction can be categorized as an immediate transaction (cash transaction). An LC essentially represents an expectation to obtain funds, goods, or services within a specified period and the credit aspect manifesting in the time difference between payment and the treatment of payment in forward transactions. If a creditor engages in credit transactions with a debtor, providing the debtor with a certain level of credit, the creditor must also bear the consequences of the debtor's failure to fulfill obligations due to subjective or objective reasons, with the extreme consequence being bankruptcy. In the case of immediate transactions, where there is no time difference between the treatment of payment, as long as the transaction does not harm the debtor's property, it cannot be deemed as a disproportionate settlement.

If LC Applicant settled the payment for goods while simultaneously obtaining equivalent merchandise, then the buying and selling relationship between two companies should be considered as an equivalent transaction that does not harm the bankruptcy estate. In this context, an LC is equivalent to such a transaction. Although LCs are forward transactions, the commitment to honor credit-complying documents by the issuing bank is made independently, not contingent on the applicant or beneficiary, and cannot be regarded as credit extended by both parties to each other. The essence of payment settlement through LCs is not different from immediate transactions and LC Applicant's settlement is not a disproportionate settlement.

I find this judgment to be quite well-written. This is because the conformity of documents triggers the issuing bank’s established obligation to make payment. The 90-day payment term is merely a credit arrangement between LC Issuer and the beneficiary, rather than a credit relationship between the applicant and the beneficiary. This is because LC Issuer ’s payment obligation is independent and there is no issue of disproportionate settlement since the obligation is not contingent on the applicant.

China Everbright Bank Co., Ltd. Jinan Branch v. Yanggu Xiangguang Copper Industry Co., Ltd₁₀

China Everbright Bank, Jinan Branch (Issuing Bank) issued a letter of credit to Yanggu Xiangguang Copper Industry Co. (Applicant) for the purchase of copper ore concentrate powder. After the goods arrived, Issuing Bank made payment on behalf of Applicant. Later, it was discovered that Applicant faced financial difficulties and applied for bankruptcy, leading to bankruptcy proceedings. Issuing Bank then thoroughly reviewed agreements between the two parties to determine the security interests it had on the bill of lading and the goods it represented, including whether it had ownership or pledge rights.

Subsequently, the bankruptcy administrator requested that the goods represented by the bill of lading at the port be included in the bankruptcy estate. Issuing Bank asserted its priority rights over the property and presented a series of documents and agreements. Later, the second-instance judgment of the Jinan Intermediate People's Court confirmed Issuing Bank's pledge priority rights.

The judgment in this case provides us with a lesson: In their standard contracts and operational processes, banks often forget to specify the most crucial aspect - what kind of security interest they have over the documents and the goods represented when documents come into possession of issuing banks. If an issuing bank is to have a pledge right, it needs a clear agreement, explicitly stating that it is a pledge right. If the issuing bank holds the client’s letter of credit security deposit, it should also be clearly stated that it is a security deposit pledge. Whether it is a bill of lading or warehouse receipt held by the issuing bank, both pledge rights require a written agreement to explicitly specify that it is a right certificate pledge.

In an LC, in addition to requiring the applicant to supplement the guarantee deposit, provide other collateral, or guarantee measures, there may also be a request for the applicant to add provision. However, the nature of provision is currently somewhat unclear in legal terms and the People's Bank of China (China's central bank) has not categorically placed provision within the legally defined scope of guarantees. Therefore, the legal status of provision is currently uncertain.₁₁

Conclusion

These letter of credit cases illustrate the importance of banks paying attention to the terms of their LC application agreements. In instances where the applicant faces financial difficulties or bankruptcy and is unable to make payment or redeem the documents to the issuing bank, the issuing bank’s rights over the documents, goods, or collateral become crucial. The specific rights held by the issuing bank, and whether registration of these rights is required for the documentary evidence, need to be clarified. In cases like Lan Yue Energy, the issuing bank must not only be concerned with its own priority rights but also consider the claims of other creditors. Therefore, the issuing bank needs to assess not only its rights but also whether registration is necessary or mere possession is sufficient.

If banks do not exercise caution in their operations, it can sometimes result in substantial losses. Therefore, banks’ legal departments need to scrutinize legal documents and clearly articulate various types of guarantee interests held by the bank.

* Saibo Jin is Senior Partner at Beijing Jincheng Tongda Law Firm. He is an expert in handling letter of credit disputes and has been an invited expert of the PRC Supreme People’s Court regarding the drafting of judicial interpretations concerning letters of credit and demand guarantees. Since August 2023, he has been designated as a member of the ICC Banking Commission’s Technical Adviser team. This article is based on part of an online lecture conducted by Mr. Jin on 12 August 2023. Apprentice lawyer Haoran Gu assisted in the translation of this article.

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